Interest-only Mortgages: Boon or Bust?

Want to own your own home in a competitive housing market? You may be considering taking out an interest-only mortgage to get your foot in the door. Formerly the tool of wealthy investors, interest-only mortgages are now widely marketed and used. When the economic climate is just right, they can be a great way for cash-strapped borrowers to buy a home. As good as they can be though, there are some serious downsides that need to be weighed before entering this arrangement.

How they work
An interest-only mortgage is actually a payment method combined with a traditional mortgage. With it, you pay only interest for anywhere between three to ten years. Once that period is over, the payment rises to include both principal and interest. Not only will your monthly costs be lower than with a conventional mortgage, but it may also be easier to qualify for the loan.

Most interest-only payment schedules are offered on adjustable rate mortgages (ARMs). After a period of fixed interest, the payment changes with whatever index (the prime lending rate, London Inter-Bank Offered Rate, Cost of Funds Index, 12-Month Treasury Average, etc.) the ARM is based on. The longer the fixed-rate period, the higher the interest rate you'll pay for that period.

The advantages
Interest-only mortgages are often used when home prices are so high that a conventional mortgage payment is out of a borrower's range. They enable you, the buyer, to borrow more money while not increasing the monthly payment, thus getting more home for your purchasing dollar.

There are other benefits as well. You can use the extra cash that an interest-only mortgage payment can leave you with to your economic advantage. Money that is not going toward the home's principal can be used to accumulate other appreciating assets, upgrade the home (not just to enjoy it more, but to increase its value), and invest for a child's higher education, your retirement, and other long term goals. It can be a very smart way of leveraging your money.

Because the principal portion of a conventional mortgage is not tax deductible, an interest-only mortgage can reduce your tax liability too. (The difference may be small though, since the bulk of a conventional mortgage payment is mostly comprised of interest in the beginning anyway.)

The disadvantages
Of course with any positive, there is also a negative. In the case of interest-only mortgages, borrowers are exposed to greater risk than with conventional loans. Using them opens you to three types of risk: market, interest rate, and cash flow:

Market risk
When the housing market is hot, it's hard to imagine that it will ever be anything but hot. However, prices do fluctuate regularly on a localized basis, and even sizzling markets can turn cold fast. As an interest-only borrower you are not building any equity early in the loan, and are counting on appreciation to help you own more of your home. This works great in periods of high growth, but a downturn in housing prices could mean that you end up owing more than you own.

Additionally, if prices do not increase during the interest-only period and you need to sell the home, you could be responsible for thousands of dollars in sales costs. While this can be paid out of the home's equity, you could be in real financial trouble if you put very little down and haven't paid anything toward the principal.

Interest rate risk
Since the interest rate for an ARM is tied to the prime lending rate or other fluctuating indexes, your mortgage payment will vary. Even a slight rate increase can mean the difference between an affordable and an unaffordable payment, particularly if your mortgage is large. Interest-only mortgages may feature a period of fixed interest, but the time frame is often very short. Make no mistake: rates may be low today, but they will inevitably rise in the future.

Cash flow risk
Because qualifying ratios have been greatly expanded, consumers can now borrow more money from the same income. In short, interest-only mortgages allow borrowers to live close to the edge or even get in over their heads. If your spending plan is already stretched to the limit, then interest rate and payment increases aren't your only concerns. For those with no savings and little, if any home equity, any decline in personal cash flow (such as a job loss, income reduction, and large or continuous unplanned-for expenses) can result in an inability to meet a mortgage payment.

Before you borrow...
Interest-only mortgages can be a wonderful way to enter the housing market. However, since they also carry more risk than conventional loans, weigh the advantages and disadvantages carefully before signing on the dotted line. Be realistic about your cash flow situation; if you can barely afford the house you are buying, you could be putting your home and finances in a perilous situation. Do not let anyone talk you into a loan that you can't afford or are not comfortable with. Keep track of the economy, since it has such a significant impact on this type of loan. A home is the most expensive and important purchase you are likely to make. So borrow sensibly now, and be prepared for change in the future.

Revised January 2016

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